Tag Archives: Jed Rakoff

In an opinion issued July 6, 2015, a Ninth Circuit panel affirmed the insider trading conviction of Bessam Salman in the case captioned United States v. Salman, No. 14-10204 (9th Cir.). The opinion is relatively straightforward, but is noteworthy for two reasons. First, it is written by Southern District of New York Judge Jed Rakoff, who seems to attracting insider trading cases of late, and has written several opinions interpreting and applying the Second Circuit U.S. v. Newman decision. Second, the defendant-appellant argued that the Newman opinion supported reversal of the conviction, which gave Judge Rakoff another chance to state his views on Newman. The opinion can be read here: U.S. v. Salman.

The opinion does little to advance the interpretive analysis of the Newman decision because it is governed directly by the Supreme Court holding in Dirks v. SEC, 463 U.S. 646 (1983). In fact, Judge Rakoff says so in no uncertain terms: “Dirks governs this case.” Slip op. at 10. The only real comment Judge Rakoff makes on Newman is that ifNewman held that a personal gift of material inside information from a tipper breaching a fiduciary duty of confidentiality to a tippee with whom he has a close relationship, for the specific purpose of enriching the tippee, was insufficient to support a conviction, then “we decline to follow it.” Slip op. at 13. Since Newman never suggested such a result – which would be plainly contrary to the Dirks opinion – there is no distance between the Salman and Newman opinions.

As Judge Rakoff notes, the facts in Salman and Newman are very different. In particular, in Newman, the evidence showed no intention by the original sources of the inside information to confer a benefit on a close friend or relative by improperly communicating the inside information. In Salman, however, the evidence in the record was exactly the opposite. The tipping brother testified “that he gave [his brother] the inside information in order to ‘benefit him’ and to ‘fulfill[] whatever needs he had.’” Slip op. at 5.

The Dirks opinion plainly included this in its description of unlawful tipping, as quoted by Judge Rakoff: “[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.” Slip op. at 10, quoting Dirks, 463 U.S. at 664.

Some may contend that Salman rejects the concept of a “personal benefit” to the source in the nature of a “quid pro quo” as a prerequisite for tippee liability, referred to in Newman. See, for example, Ninth Circuit Disagrees with Second Circuit on Personal-Benefit Requirement for Insider Trading. That is not how I read either Salman or Newman. Newman never questioned that the required benefit to the tipper could be a non-monetary one — like the benefit of directing wealth to a close friend or relative you want to benefit from being more wealthy — it just found the evidence of such a benefit insufficient in that case because the mere fact of providing information, with no evidence that it was to fulfill the tipper’s desire to transfer wealth, was “too thin” to support finding a benefit to the tipper. And Salman plainly finds, and emphasizes, the strong evidence in the case of a benefit to the tipper in the form of intentionally directing wealth to a beloved relative.

There can be no doubt that the Newman court never rejected that holding in Dirks. Instead, it tried to apply the Dirks holding to the evidence presented in Newman, which the court found insufficient to show any personal benefit derived by the sources from their “tips” because “the mere fact of a friendship, particularly of a casual or social nature” was not enough to prove a intent to benefit the tippee. Slip op. at 12-13, quoting Newman, 773 F.3d at 452. The Newman court found the “circumstantial evidence” in that case “too thin to warrant the inference that the corporate insiders received any personal; benefit in exchange for their tips.” Slip op. at 13, quoting Newman, 773 F.3d at 451-52. That obviously does not describe the evidence of benefit presented in Salman, which was neither circumstantial nor thin because the source himself described the pleasure he took in giving the gift of information to his brother. See slip op. at 11 (testimony from the source and his tippee, who were brothers, showed that the tipping brother “intended to ‘benefit’ his [tippee] brother and to ‘fulfill[] whatever needs he had’”).

If Salman stands for anything meaningful, it is that it shows that Newman was not a meaningful departure from existing insider trading law, but rather a ruling that there are limits to how far the Government can stretch mere casual friendships or acquaintances to prove a transfer of information was intended as the “gift of confidential information” described in Dirks. In short, the sky did not start falling when the Newman opinion was adopted. See DOJ Petition for En Banc Review in Newman Case Comes Up Short.

Judge Rakoff’s Salman opinion concludes: “If Salman’s theory were accepted and this evidence found to be insufficient, then a corporate insider or other person in possession of confidential and proprietary information would be free to disclose that information to her relatives, and they would be free to trade on it, provided only that she asked for no tangible compensation in return. Proof that the insider disclosed material nonpublic information with the intent to benefit a trading relative or friend is sufficient to establish the breach of fiduciary duty element of insider trading.” Slip op. at 14. Newman never suggests any different result.

Our Friday post did not discuss any of the SEC’s vague descriptions, all-encompassing caveats, prevarications, and self-congratulatory pats on the back (to itself) in this document, so we will address some of them here. This SEC memo is the equivalent of one of those “what were they thinking?” moments we now see on the internet all of the time, like a selfie someone might take (and actually post for all to see) of the author grinning before some solemn background, like the Vietnam War Memorial. It’s an embarrassment for what it says and what it fails to say about the serious issue of assuring due process and fair treatment in SEC enforcement actions, particularly as to non-regulated persons.

“When recommending a contested enforcement action to the Commission, the Division recommends the forum that will best Utilize the Commission’s limited resources to carry out its mission.”

A false and misleading statement in at least two respects. The Director of the Division of Enforcement already admitted that the Division chooses its administrative forum to pressure targets into settlement (“I will tell you that there have been a number of cases in recent months where we have threatened administrative proceedings, it was something we told the other side we were going to do and they settled”), and that he believed federal court juries were not properly adhering to the required burden of proof (“Frankly, I think juries, while they’re instructed that we have a preponderance standard, I think apply a higher standard to us than preponderance”). See SEC Could Bring More Insider Trading Cases In-House. That has nothing to do with “best utilizing resources”; it has to do with maximizing the chance to win or force a settlement on SEC terms. One of the key reasons for choosing the administrative forum is because it has a better chance of winning there, not to make careful use of enforcement resources. And, as the Wall Street Journal recently documented, that is precisely the result. The Division also makes no real effort to “best utilize” its resources in any other enforcement context. It badly allocates its ample staff resources on investigative matters that have little overall public policy consequence. That includes the so-called “broken windows” approach to enforcement, which focuses staff attention on what the SEC itself describes as minor violations. But it also includes expensive litigated cases involving trivial violations of law, even if all the allegations could be proved. (See There They Go Again: SEC Wasting Taxpayer Dollars on Trivial Perquisite Enforcement Litigation in SEC v. Miller.)

“There is no rigid formula dictating the choice of forum. The Division considers a number of factors when evaluating the choice of forum and its recommendation depends on the specific facts and circumstances of the case. Not all factors will apply in every case and, in any particular case, some factors may deserve more weight than others, or more weight than they might in another case. Indeed, in some circumstances, a single factor may be sufficiently important to lead to a decision to recommend a particular forum. While the list of potentially relevant considerations set out below is not (and could not be) exhaustive, the Division may in its discretion consider any or all of the factors in assessing whether to recommend that a contested case be brought in the administrative forum or in federal district court.”

A long-winded way of saying: “We are going to list a whole lot of factors below, but there is no way to know which ones we will decide are important, or whether we will decide other unmentioned factors are more important. That is, the Division will choose a forum on whatever basis it thinks makes sense, and we are not going to give you any way of predicting or understanding that decision”

“The Division may in its discretion consider . . . [t]he cost ‐ , resource ‐ , and time ‐ effectiveness of litigation in each forum. . . . In general, hearings are held more quickly in contested administrative actions than in contested federal court actions. . . . When a matter involves older conduct, this may allow for the presentation of testimony from witnesses who have a fresher recollection of relevant events.”

In other words, since administrative proceedings move more quickly, that can justify our choice of that forum in pretty much any case. And in an “older case” — which means, by the way, cases that Division of Enforcement lawyers have sat on for years on end — because our dilatory investigation makes it virtually impossible for any witness to remember accurately what really happened, we will lean towards the administrative forum because, in our discretion, we now think it is important to move at a breakneck pace, and not allow the defense the time to develop a complete understanding of the record or what witnesses may say at trial.

“The additional time and types of pre‐trial discovery available in federal court may entail both costs and benefits, which should be weighed under the facts and circumstances of a case. Although pre‐trial discovery procedures exist in both administrative proceedings and district court actions, the mechanisms of discovery are different. For example, in administrative proceedings, the Division must produce to respondents all non‐privileged documents from its case file and the Division has Brady and Jencks obligations, requirements that do not exist in civil district court litigation. On the other hand, depositions are available in district court but generally not in administrative proceedings.”

This is no more than a transparent effort to create the misleading impression that a sow’s ear could be something other than a sow’s ear. No aspect of the discovery limits in administrative proceedings are beneficial to a respondent. The restrictions on discovery may be the single-most unfair aspect of these proceedings, but the SEC portrays them here as cutting both ways. Hogwash! (In keeping with the sow metaphor.) The lack of depositions, the inability to pursue reasonable discovery against the SEC, the more restrictive approach to third-party discovery (including that every subpoena must get prior approval from the ALJ, inevitably over opposition from the Division), and the incredibly short time-frame for doing any independent development of evidence, all mire the administrative respondent in a sloppy mud pen. The SEC, however, had many years to develop its own case (and now uses its own delay as a reason to avoid court!), and no obligation to do so in a way that actually makes a fair record (in investigative testimony, leading and misleading questions, hiding key evidence from witnesses, vague questions that can be later misconstrued, and avoiding any discussion of exculpatory evidence, are the norm). So the much-touted production of “all non-privileged documents from its case file” is a laugher as a benefit to the respondent. The same production would be required in court (and typically is made by the SEC at the outset without waiting for a request), and intelligent discovery requests will be able to garner all Brady and Jencks material as well. Not to mention the fact that the Division’s concept of what is “non-privileged” means they often refuse to produce many materials based on privilege claims (attorney-client, work-product, and the all-encompassing “deliberative process privilege”) that would not (and do not) withstand challenge in court. But administrative judges are much more reluctant to force discovery on the Division, or the SEC more broadly, than federal court judges.

“Administrative Law Judges, who adjudicate securities law cases, and the Commission develop extensive knowledge and experience concerning the federal securities laws and complex or technical securities industry practices or products. . . . If a contested matter is likely to raise unsettled and complex legal issues under the federal securities laws, or interpretation of the Commission’s rules, consideration should be given to whether, in light of the Commission’s expertise concerning those matters, obtaining a Commission decision on such issues, subject to appellate review in the federal courts, may facilitate development of the law.”

The hubris! This could be the most offensive factor of all. It suggests that administrative law judges and SEC Commissioners are better-suited to decide “unsettled and complex legal issues” to “facilitate development of the law” than federal court judges. Let me see if I have this right. An appointee not required to meet anything close to the standards that apply to federal judges is better to decide complex issues and the development of the law? And Commissioners, who have virtually no adjudicative experience at all when they are appointed, all of a sudden become better at considering “complex and unsettled legal issues” when they are confirmed? I think not. Nor does district judge Jed Rakoff, who gave the exact opposite view on this issue (moving cases from the federal courts to the SEC’s captive administrative court “hinders the balanced development of the securities laws”). SeeJudge Rakoff Slams SEC for Increased Use of Administrative Proceedings.

The SEC was not content here to talk about technical applications of SEC rules in the securities industry — as to which they could at least have a theoretical basis for making such an argument based on supposed agency expertise. They argue here that ALJs and Commissioners may be viewed as better able to decide complex legal issues wholly apart from technical SEC regulatory compliance issues — for example, whether a non-regulated corporate official engaged in fraud in some respect or another. There is no way to support the argument that ALJs or SEC Commissioners are better situated to decide complex and unsettled issues involving fraud allegations than federal judges. The obvious example is insider trading cases, as to which the law is so nuanced, and so bound up in considerations of fraud and fiduciary obligation, that federal court judges are much more likely to get it right. (The exact view expressed by Judge Rakoff: seeJudge Rakoff PLI Speech.) That doesn’t even take into consideration the fact the federal judges (and juries) are not conflicted on these cases like the SEC Commissioners are. Only after having first approved the filing of a prosecution, and likely having rejected a proffered settlement as insufficient, do the Commissioners decide these cases, including whether to adopt views of the facts or the law that may be inconsistent with their own decision to prosecute.

As an attempt to make public policy, this document is an embarrassment. Its objective is not to determine when an administrative forum is a fairer and more appropriate forum in which to litigate enforcement actions against non-regulated persons. It is to provide a justification for any decision the SEC may make about where to litigate its cases, and to be able to argue that those decisions deserve deference because they reflect a reasoned agency determination under an adopted set of guidelines

The fact that Chair Mary Jo White signed off on such an atrocity is depressing, and, frankly, inexplicable.

The article points out that the SEC has not so mysteriously increased its use of the administrative courts in apparent response to losing more cases in its federal court enforcement actions. (The SEC’s Director of the Division of Enforcement admitted that they chose a forum based on the desire to win and to pressure their targets into settlement.) The federal court actions allow the accused to present a defense to real folks, not administrative judges, who happen to be chosen by, work within, and report to, the SEC itself. (Ms. Eaglesham quotes Judge Jed Rakoff: “The SEC appoints the judges, the SEC pays the judges, they are subject to appeal to the SEC. That can create an appearance issue, even if the judges are excellent, as I have every reason to believe they are.”) There are no standards that cabin SEC discretion to choose when it can deprive an accused of a jury trial simply by choosing to use the administrative court. This presents obvious Seventh Amendment issues, as well as arbitrariness issues under the Administrative Procedure Act, that no court has yet addressed. Indeed, the SEC is actively trying to prevent federal courts from addressing these issues, and so far has been successful.

Ms. Eaglesham also reports, to my knowledge for the first time, about internal pressures on SEC administrative law judges to side with the SEC or be accused of a lack of “loyalty”:

One former SEC judge said she thought the system was slanted against defendants at times. Lillian McEwen, who was an SEC judge from 1995 to 2007, said she came under fire from Ms. Murray for finding too often in favor of defendants.

“She questioned my loyalty to the SEC,” Ms. McEwen said in an interview, adding that she retired as a result of the criticism.

Ms. McEwen said the SEC in-house judges were expected to work on the assumption that “the burden was on the people who were accused to show that they didn’t do what the agency said they did.”

This is a grave charge that needs independent investigation. If true, it would raise serious due process issues. It certainly provides sufficient grounds for the SEC to be subjected to discovery in a federal court action seeking to prevent the SEC from imposing sanctions in a court infected with inherent bias, if the SEC’s efforts to prevent such an action from going forward can be overcome.

Ms. Eaglesham has done us a service by exposing the SEC’s festering sore to the open air. We can only hope that a little sunlight will penetrate the SEC’s defensive shell and allow a full and fair consideration of the serious issues being raised.

Several commentators have speculated that Judge Rakoff’s denial of the defendants’ motion to dismiss in SEC v. Payton potentially stripped the Second Circuit’s U.S. v. Newman decision of significant impact in SEC insider trading enforcement proceedings. See, for example,Remote Tippees Beware: Even if the DOJ Can’t Reach You After Newman, The SEC Can, andInsider Trading: Does Payton Begin the Erosion of the Newman Tipping Test?Are they correct? The short answer from this writer’s perspective is “No.” I have two reasons for saying this. First, it is a decision on a motion to dismiss, and almost all of the positions taken in it flow from the extremely low bar set for sufficiency of complaints, especially when the plaintiff is the government. Second, the opinion is fundamentally flawed by the failure to perform the kind of analysis that Newman – and its doctrinal ancestors Chiarella v. United States and Dirks v. SEC – mandate. Judge Rakoff’s opinion is available here:Denial of Motion To Dismiss in SEC v. Payton.

This Was Only a Ruling on a Motion To Dismiss.

First, the opinion addressed a motion to dismiss. All such motions face steep obstacles, especially when the plaintiff is the government (I doubt if 0.1% of the motions to dismiss SEC actions are successful.) The SEC knew that its amended complaint had to make allegations to get past a motion, and it was designed to do so. Whether the evidence will support those allegations is another story entirely.

Judge Rakoff’s opinion is, as it must be, dependent on accepting all possible inferences that may be drawn from facts alleged in the complaint. So, after reciting the allegations, he writes: “drawing (as required) every reasonable inference in plaintiff’s favor,” he finds the allegations of the tippers “intent to benefit” sufficient. Slip op. at 13. He continues: “More generally, taking all the facts in the complaint as true and drawing all reasonable inferences in favor of the SEC, the amended Complaint more than sufficiently alleges that [the tipper and tippee] had a meaningfully close personal relationship and that [the tipper] disclosed the inside information for a personal benefit sufficient to satisfy the Newman standard.” Id. Likewise, his later discussion of allegations relating to the scienter of the downstream tippees who are the defendants in the action, Messrs. Payton and Durant, concludes: “Thus, taking these allegations as true and drawing all reasonable inferences in favor of the SEC, the Amended Complaint more than sufficiently alleges that defendants knew or recklessly disregarded that [the tipper] received a personal benefit in disclosing information to [the tippee], and that [the tipper] in doing so breached a duty of trust and confidence to the owner of the information.” Slip op. at 16.

The rubber meets the road with the introduction of evidence, and its consideration by the trier of fact. Judge Rakoff’s opinion says, and can say, little about that. Especially if the trier of fact is a jury, the jurors’ willingness to find the tippee’s “intent to benefit” the tipper, and the remote tippees’ intent to engage in a fraud, based on the relatively meager facts alleged is another thing entirely. Some people may think that Judge Rakoff’s willingness to draw those inferences from the allegations is powerful because he is a bright, outspoken, and well-regarded district court judge. But they should first consider his background as a former prosecutor, and then recall that his most notable recent decisions involving SEC cases criticize the SEC for (i) not prosecuting aggressively enough, and (ii) accepting settlements without sufficient justification in support of the agreed-upon terms. It is hardly surprising that his review of the complaint reflects a pro-prosecution frame of mind.

In the end, allegations about benefits allegedly flowing between tippers and tippees are bound up in the facts and circumstances of each case. That Judge Rakoff found those allegations sufficient here says little about what another judge will say about other facts elsewhere, or what anyone, even Judge Rakoff, would do when faced with evidence, not allegations. More important is the mindset that should be used to evaluate the sufficiency of such allegations. It is in that respect that Judge Rakoff’s decision misses the mark, and why it should not be accorded future deference.

The Opinion Misses the Mark Because It Fails To Focus on Whether Fraud Is Alleged

Judge Rakoff seems so interested in exploring how the SEC might satisfy the “intent to benefit” standard laid out in U.S. v. Newman that he ignores the more critical issue raised by the allegations, and focused upon in Chiarella and Dirks. He starts out on the wrong track, and never addresses the core, important issue. His statement of the driving factors behind insider trading violations is wrong, and he immerses himself in issues that, while perhaps interesting from a jurisprudential standpoint, make little difference to the claims asserted in the complaint. He fails to ask the most important question in these cases: accepting the allegations as stated, do they provide grounds for inferring that the defendants engaged in fraud in connection with their purchases or sales of securities. The entire discussion of the facts alleged never once seeks to answer that question.

The opinion reflects this flaw from the outset. Here is what Judge Rakoff says in his first paragraph:

As a general matter, there is nothing esoteric about insider trading. It is a form of cheating, of using purloined or embezzled information to gain an unfair trading advantage. The United States securities markets — the comparative honesty of which is one of our nation’s great business assets – cannot tolerate such cheating if those markets are to retain the confidence of investors and the public alike.

Slip op. at 1.

This may sound good, but it is wrong. Insider trading is not “a form of cheating”; it is a form of “fraud” in the context of securities transactions. Even if we give the judge the benefit of the doubt and assume that in his mind “cheating” and “fraud” are equivalents, the error of his statement is apparent in the remainder of that sentence, because insider trading certainly is not “using purloined or embezzled information to gain an unfair trading advantage.” That is wrong in two respects. The use of “purloined” information is not enough to support an insider trading violation because it lacks the aspect of deceit required to prove fraud. (“Purloined” is a fancy way of saying “stolen.”) And insider trading is not at all about having a “trading advantage,” fair or unfair.

In a “classical” insider trading case, one might argue that the transaction is “unfair” because the counter-party can theoretically expect an insider, under the law, to disclose material information before trading, but the real point is the breach of the disclosure duty (which constitutes fraud), not the fairness or unfairness of the transaction. In a “misappropriation” case, this description makes no sense at all, because in such cases, the victim of insider trading fraud is the owner of the information, who was deceived into sharing that information with someone who used it for an unauthorized purpose. The notion that the counter-party to the trade was a victim of an “unfair” transaction reflects acceptance of an equality of information standard in the marketplace, which plainly is not the law. The securities transaction itself need not be “unfair,” and it probably is not, because the counter-party is a willing participant getting the price he wants in a transaction with a stranger.

I focus on this only to show that from the very outset, Judge Rakoff is using language and a mindset that is inconsistent with the law, as laid out by the Supreme Court. As Judge Rakoff points out, there is no statute that prohibits insider trading, no less attempts to define it. Instead, insider trading violates section 10(b) of the Securities Exchange Act of 1934 if, and only if, the transaction is accomplished by means of fraud. This fundamental difference, between focusing on a concept of “fairness” rather than a concept of “fraud,” infects Judge Rakoff’s analysis.

Fraud, as we know, requires intentional deceit. Judge Rakoff says that because the Second Circuit’s opinion in Newman came in a criminal case, it may not control SEC civil cases because there may be instances where conduct that does not constitute criminal “insider trading” may still be considered “insider trading” in an SEC civil action. To be sure, the state of mind requirement for a criminal conviction – “willfulness” – does not apply to SEC civil cases. But even if one engages in a “reckless” fraud (if that concept makes sense, an issue not yet decided by the Supreme Court), it must nonetheless be a “fraud.”

To understand where Judge Rakoff’s opinion flies off the rails, we need to review the facts alleged in the complaint. Defendants Payton and Durant, are what is known as “remote tippees.” In this case, quite remote.

The “owner” of the information. The information in question was a planned acquisition by IBM of another company, SPSS, Inc. The “insider,” and “owner” of that nonpublic information was IBM and SPSS. But no one at IBM or SPSS traded, or shared information with others for the purpose of trading.

The original “tipper” and original “tippee” of the information. Instead, the information was learned by a lawyer at the Cravath law firm, Michael Dallas. Mr. Dallas obtained the information lawfully; there is no suggestion he did so deceitfully. Dallas had a close friend, Trent Martin. They engaged in many allegedly confidential conversations, although Dallas surely must have understood that he was not supposed to share client information with a third party, even a close friend. It is alleged that “Martin and Dallas had a history of sharing confidences such that a duty of trust and confidence existed between them. . . . They each understood that the information they shared about their jobs was nonpublic and both expected the other to maintain confidentiality.” Dallas allegedly shared specific information about the IBM/SPSS merger with Mr. Martin on several occasions. There is no allegation that the conduct of either Dallas or Martin relating solely to the sharing of this information between them was fraudulent. Since Dallas gained possession of the information as part of his work, he would not be a “tippee.” But there is no apparent authorization for communicating the information to Martin, so Martin should be considered a “tippee.” That would make Dallas the original “tipper,” and Martin the original “tippee.” Judge Rakoff calls Martin the “tipper”; that is right in the sense that he transferred the information to a second-level tippee, but Dallas plainly makes the first “tip,” although it was not alleged to be fraudulent, and Martin is not alleged to have traded SPSS securities.

The second-level tippee. Martin shared housing with Thomas Conradt. It is alleged that “They shared a close, mutually-dependent financial relationship, and had a history of personal favors.” Focusing on pleading facts that will pass muster under Newman, the complaint describes several respects in which they assisted or did favors for each other. It also alleges that Martin, “in violation of his duty of trust and confidence to Dallas, tipped inside information about the SPSS acquisition to Conradt,” who bought SPSS securities. This makes Mr. Conradt a “second-level tippee.”

The third-level tippee. Conradt worked at the same brokerage firm as a registered representative identified as “RR1.” Conradt allegedly told RR1 about the SPSS transaction. That makes RR1 a “third-level tippee.”

The fourth-level tippees. Defendants Payton and Durant also worked at the same brokerage firm as Conradt and RR1. It is alleged that Conradt “learned that RRl had, in turn, shared the inside information with defendants Payton and Durant.” That makes the defendants “fourth-level tippees.” The complaint also alleges that after hearing about this, Conradt told Payton and Durant that he got the information about SPSS from his roommate, Martin. “On the basis of the inside information they learned from RRl and Conradt, defendants purchased SPSS securities.”

The SEC cause of action is against Payton and Durant. So the question to ask is: How do the allegations try to show that Payton and Durant committed acts of fraud in connection with their purchases of SPSS securities? Judge Rakoff says the following: (1) They knew that Martin was Conradt’s roommate, and that the information about SPSS went from Martin to Conradt to RR1; (2) Conradt told Payton that Martin had been arrested for assault; (3) they never asked Conradt why Martin had given him information about SPSS or how Martin had learned the information; (4) after the IBM/SPSS merger was disclosed to the public, they met with Conradt, RR1 and another Conradt tippee “to discuss what they should do if any of them were contacted by the SEC or other law enforcement,” and they “agreed not to discuss the trading with anyone and to contact a lawyer if questioned”; (5) Payton took steps to hide his transactions; and (6) after receiving an SEC subpoena, they lied to their employer about the origin of their interest in SPSS securities.

These alleged facts simply do not add up to adequate allegations of fraudulent conduct by defendants Payton and Durant, and certainly not under the strict pleading requirements for stating fraud claims under Fed. R. Civ. P. 9(b), which applies to this claim.

Why not? To put it simply, there is no allegation of any deceptive act by the defendants leading up to, and consummating, their purchases of SPSS securities. The bulk of Judge Rakoff’s opinion focuses on the relationships and reasons for communications between Dallas, Martin, and Conradt. Dallas and Martin allegedly had a close confidential relationship, and Martin and Conradt allegedly had “a close, mutually-dependent financial relationship” and “a history of personal favors.” But Conradt is not alleged to have had any special relationship with RR1 or the defendants, and RR1 is not alleged to have had any special relationship with the defendants. Nor are there any allegations that the defendants (Payton and Durant) knew about the existence of the source of the information, Dallas, or anything about nature of the relationship between Dallas and Martin, or Martin and Conradt, other than that Martin and Conradt were roommates and Martin had been arrested for assault.

Nothing about any of these facts suggests Payton and Durant defrauded anyone up to, and including, the consummation of their SPSS security purchases. No facts suggest they owed a duty to disclose anything about what they knew (or, more accurately, were willing to bet on) about a possible IBM/SPSS merger before trading SPSS securities. They were not insiders, and, as alleged, had no knowledge that the information they learned originated with an insider. As a result, there is no basis for finding a duty of disclosure from them to SPSS shareholders. And they had no knowledge that the information they learned had been “misappropriated” from its owner – the only possible owner they knew about was Martin (they are not alleged to have known anything about the relationship of Dallas and Martin), and they had no reason to believe that Conradt misappropriated information from Martin. In fact, the SEC complaint makes it clear that Mr. Conradt did not misappropriate the information from Mr. Martin, since it alleges that Martin intentionally “tipped inside information about the SPSS acquisition to Conradt.”

Judge Rakoff dwells on the alleged fact that neither Payton nor Durant asked Conradt about why Martin gave information to Conradt and how Martin got the information in the first place. But no fact alleged suggests they were under any duty to ask such questions. To be sure, the “willful blindness” doctrine might preclude them from arguing lack of that knowledge in defending the scienter element, although willful blindness seems a stretch here, but Judge Rakoff provides no reason why they had any legal duty to ask such questions before trading on the information they learned from RR1 and Conradt.

So where is fraud alleged against Payton and Durant? Whether an insider trading violation is viewed under the classical or misappropriation theory, it must be founded in deceiving someone by failing to disclose material nonpublic information in advance of trading, when such disclosure is required. That is the fraud. Under the classical theory, a prior disclosure of the information to the counter-party cures any claim of fraud because the disclosure duty is satisfied, eliminating any insider trading liability (the so-called “disclose or refrain from trading” requirement). Under the misappropriation theory, a prior disclosure to the owner of the information of the intent to trade on the basis of the information eliminates the fraud, which is the undisclosed use of the information to trade (assuming the relationship with the owner created a duty to disclose). In each instance, the insider trading liability flows from the deceptive breach of the duty of disclosure.

But no allegation in the complaint identifies any person to whom Payton and Durant owed a duty of disclosure. There is no disclosure they could have made to allow them to go forward with the trades (to satisfy the “disclose or refrain” mandate) because there is no disclosure they were required to make to anyone, based on the allegations in the complaint. Not to Dallas, whom they didn’t know existed; not to Martin, with whom they had no relationship, and to whom even Conradt owed no disclosure duty because he had been given the information without any promise of confidentiality; not to RR1 or Conradt, neither of whom is alleged to have had a special relationship with the defendants, and both of whom knew about their trading anyway; and not to any shareholder of SPSS, because the defendants were not insiders, or even “constructive” insiders by virtue of knowing their information was confidential and originated with insiders.

What about all the alleged post-trading conduct that supposedly evidences “guilty knowledge” or the like? I would argue those allegations could be equally explainable by the defendants’ fear that the authorities or their employer would be concerned about, and would certainly investigate, the trades, even if they were not unlawful. Does Judge Rakoff really believe that running away from the police is evidence of having committed a crime? Even a former prosecutor should be wary about making that connection. In any event, no amount of allegedly incriminating post-trading conduct can turn a lawful trade into an unlawful one. Such conduct would have a bearing on the issue of scienter, but all the scienter in the world doesn’t create a violation where there was none. “Guilty knowledge” doesn’t count for much if the person is, based on the alleged facts, not guilty.

Judge Rakoff discusses none of this, and that is why the opinion is fundamentally flawed. One gets the sense that his overall objective is to try to make sure that people who he believes “cheated” would be held accountable because, as he says it: “The United States securities markets . . . cannot tolerate such cheating if those markets are to retain the confidence of investors and the public alike.” But that is a legislative thought, not a judicial one. He is bound to adjudicate within the strictures of section 10(b), which he does not do. He is so focused on trying to show that the allegations could support an inference satisfying the Newman intent to benefit standard that he ignores the core meaning and analytical framework of Newman, and of Chiarella v. United States, and Dirks v. SEC as well: that fraud is what section 10(b) is all about, not supposedly unfair informational advantages or even sketchy opportunism by traders. The whole point of Newman’s intent to benefit requirement is to assure that nonpublic information known to a trader is the result of fraudulent conduct, not something else, before that person can be found liable under section 10(b), criminally or civilly. A tipper’s unauthorized and undisclosed transmission of information to a tippee simply is not fraudulent unless it is done to obtain some form of tangible benefit that was the object of fraud.

Judge Rakoff’s opinion does nothing to explain how these fourth-level tippees could have section 10(b) liability under the facts alleged. Because the allegations in the complaint in SEC v. Payton fail to provide plausible inferences that their securities trades were founded on fraudulent conduct, not to mention particularized allegations of the fraud (which at least would require identifying the persons defrauded and how), the complaint fails to state a claim under section 10(b), and should have been dismissed.

In addition to joining the DOJ in the effort to get the panel decision in United States v. Newman reconsidered en banc, the SEC continues to pursue arguments in lower courts to emasculate the substance of the Newman decision. The latest example of that is in SEC v. Payton and Durant, No. 14-cv-4644 (S.D.N.Y.), which is the SEC civil enforcement action that parallels DOJ criminal actions in U.S. v. Durant and U.S. v. Conradt.

The SEC’s civil action was originally filed against Payton and Durant in June 2014, well before the Second Circuit’s December 2014 Newman decision. The allegations were essentially as follows. Michael Dallas, a lawyer at the Cravath firm, learned about the IBM transaction from his work at the firm and discussed the impending IBM transaction with his close friend, Trent Martin. Dallas and Martin supposedly had a close confidential relationship, and Martin supposedly knew the information was to be kept confidential. Martin nevertheless traded securities based on that nonpublic information, which the SEC alleges was a “misappropriation” of the information. Martin also conveyed the information to his roommate, Thomas Conradt, but there was no allegation that Martin received anything for the information, told Conradt how he obtained the information, or intended it as a gift to Conradt. Conradt traded on the information and also shared the information with co-workers Payton and Durant. There was no allegation that Conradt told Payton or Durant how Martin learned the information. The original complaint can be found here: Original Complaint SEC v. Payton.

In short, defendants Payton and Durant are alleged to be tippees several times removed from the original source, Dallas, the Cravath lawyer. The SEC pleads Martin’s communication of the information as a “misappropriation,” but it was effectively an unauthorized transfer of information from Dallas. In any event, Payton and Durant were alleged to have no involvement in, or knowledge of, the circumstances of the Dallas to Martin information transfer, or the Martin to Conradt information transfer.

The allegations about the transfer of information from Conradt to Payton and Durant were slim, indeed. They all were alleged to be co-workers and friends, and then the complaint alleges:

On or prior to July 20, 2009, Conradt disclosed to both Durant and Payton the Inside Information, including the names of the parties to the impending transaction, the price, and that the deal would occur soon.

At the time Conradt disclosed this information to Durant and Payton, he also informed them that his friend and roommate had disclosed the information to him.

In other words, all that was alleged was that Conradt disclosed the information to Payton and Durant, and that he learned the information from his friend and roommate. There can be little doubt that this falls short of the Newman requirement that tippees must have specific grounds to believe that the original information transfer was fraudulent.

Thus, it seems pretty plain that the original complaint failed to support an insider trading claim under the Newman standards. But after Newman was decided, the SEC chose not to amend its complaint. On February 23, 2015, the defendants moved to dismiss the complaint, laying out the reasons why the allegations did not support a claim of insider trading fraud against either Payton or Durant. The memorandum in support of that motion is here: Motion To Dismiss in SEC v. Payton.

The SEC did not bother to defend the original complaint. After the motion to dismiss was filed, it amended the complaint. (See here: Amended Complaint SEC v. Payton.) This is not unusual. Like many plaintiffs, the SEC often files relatively minimalist complaints, hoping it can get by with only minimal factual allegations. That causes the defendants to incur costs on a motion to dismiss, and allows the plaintiff to learn from the motion papers, and respond by filing an amended complaint, without even trying to oppose the motion. (Other plaintiffs have the excuse that they often lack access to key information needed to draft a more complete complaint. But the SEC has no such excuse – it fully investigates the facts with subpoena power before a case gets filed.) Here, the legal insufficiency of the original complaint should have been obvious after Newman was decided. The SEC lawyers should not have caused the defendants the substantial expense of preparing motion papers on the original allegations if they knew – as they must have – that they would amend the complaint if a motion were filed. In a fair world, the costs of preparing that motion would be charged to the SEC.

In its amended complaint, the SEC expanded its discussion of the nature of the interactions between Martin and Conradt, including alleging that Conradt helped Martin with some legal problems, and Martin was grateful for the help. However, not much was added in the amended complaint about how much Payton and Durant knew about the Martin-Conradt interactions, or about how Martin came by the information. Here is what the amended complaint says on that issue:

Both defendants Payton and Durant had experience in the securities industry prior to their employment at the Broker. Accordingly, Payton and Durant often assisted Conradt in his duties at the Broker. Among other things, Payton and Durant gave Conradt advice on good Broker-approved stocks for clients, helped him with work problems, and provided him leads for new clients. For example, in mid-June 2009 an issue arose regarding commissions Conradt felt he was owed by Broker. Conradt turned to Payton and Durant for their advice and Payton interceded with Conradt’s supervisor. Conradt thanked Payton and Durant for their help and wrote to Payton, “I owe you one.”

Prior to July 20, 2009, Conradt had discussed both his apartment and his roommates with defendants Payton and Durant. Both Payton and Durant knew that Martin was Conradt’s roommate and friend, and that Martin worked at a securities firm. Additionally, Conradt told Payton about Martin’s assault arrest near Grand Central Station.

On or before June 24, 2009, Conradt told RR1 the Inside Information. On June 25, 2009, RR1 purchased 20 July SPSS call options with a strike price of $35.

On or before July 1, 2009, Conradt learned that RR1 had told defendant Durant the Inside Information that Conradt had previously told RR1. Conradt then personally told defendants Payton and Durant that his roommate Martin had told him that SPSS was likely going to be acquired. Knowing that Conradt was Martin’s roommate, Payton and Durant did not ask Conradt why Martin told Conradt the Inside Information and did not ask Conradt how Martin learned this information.

In other words, there is no allegation that Payton or Durant were told anything about the nature, propriety, or impropriety, of the transfer of information from Dallas to Martin, or the reason why the information was transferred by Martin to Conradt. The best the SEC could do on those points was alleged that they “did not ask why Martin told Conradt the Inside Information and did not ask Conradt how Martin learned this information.”

This would appear to fall well short of the Newman requirement that distant tippees have a factual basis to believe the earlier information transfers were fraudulent. Payton and Durant are alleged to have known nothing about those transfers – for all they knew, Martin’s knowledge and transfer of the information was not unlawful, nor was Conradt’s. The complaint tries to turn that lack of knowledge into an asset, on the apparent theory that Payton and Durant had a duty to learn the answer to those questions before trading on the information. If this theory of liability were accepted, Newman would be effectively nullified. Even without knowledge, distant tippees would become liable for not inquiring into the basis for information communicated to them. Here is the SEC’s memorandum arguing that the amended complaint is sufficient: Opposition to Motion To Dismiss in SEC v. Payton.

Judge Jed Rakoff, who is presiding over the case, had a hearing with counsel after the SEC amended its complaint. Presumably, at that hearing the court adopted a schedule for defendants to file a new motion to dismiss the amended complaint and supporting memorandum that addresses the new allegations in the amended complaint. I look forward to seeing how defense counsel treat the SEC’s latest legerdemain on stating insider trading fraud claims under section 10(b).